THE REAL ECONOMY
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January 07, 2015

U.S. Growth Poised to Surge

Improving fundamentals should result in a broad-based increase in economic activity driven by an expansion of small and middle market firms that make up the real economy. Amid a tightening labor market, rising real wages and disinflation, the U.S. economy will probably grow on average 2.7 percent this year with some possibility of a faster pace of growth above 3 percent.

Momentum generated in the final three quarters of 2014 will spill over into the early portion of 2015. Growth will likely be somewhat faster in the first half of this year, bolstered by lower gasoline prices, and then slow slightly in the second half as the lagged impact of recent U.S. dollar appreciation affects foreign demand.

Key Growth Drivers

Source: RSM

The composition of U.S. growth should improve with household sector, manufacturing and business investment boosting total economic activity. U.S households benefiting from income growth, sharply lower gasoline prices and an improved balance sheet should lead the way.

Real consumption will probably increase near 2.7 percent, up from the cyclical average of 2.2 percent. The record increase in civilian aircraft orders and the surge in unfilled orders for motor vehicles and parts should keep U.S. assembly lines humming throughout the year as the revival of the domestic manufacturing sector continues.

The 7 percent growth trend in capital expenditures (through the end of the third quarter of last year) is helping boost fixed business investment. That growth will be broad-based with small and medium-sized enterprises finally joining the party and increasing their investments in software and equipment.

As well, growing confidence in the sustainability of aggregate demand should result in large corporations reducing stock buybacks and instead focusing on increasing dividends and capital expenditures. This shift is key to an improved employment picture, greater productivity and rising living standards. The difference between a solid 2.7 percent rate of growth and a better than 3 percent rate of expansion will be the choices made by middle market and large firms regarding capital expenditures, which carry the potential to offset the mild slowing of capital investment in the energy sector this year.

Interest Rate Outlook and the Fed

The interest rate outlook will remain relatively stable even with the Federal Reserve likely raising rates in the second half of the year to better align policy with an economy that is growing above the long-term trend rate of 2.15 percent. The Fed summary of economic projections (SEP) implies that the upper end of the Federal funds target rate could reach as high as 1 percent by the end of this year, and 2.5 percent by the end of 2016. We anticipate that the central bank will remain cautious and may choose to raise rates at a pace slower than that implied by the SEP because of the sharp fall in inflation expectations, economic deceleration abroad and concerns about the condition of the U.S. housing market.

While rates at the short end of the Treasury curve will continue to rise, the long end should remain relatively unchanged and continue to move in a range between 2.2 and 2.5 percent. This will be due, in part, to external capital flows into the U.S. as investors try to profit from policy divergence among the major central banks and differentials in interest rates, growth and inflation expectations among the major world economies.

Employment

The trend in employment gains should continue near the six-month average of 258,000 new jobs per month and the unemployment rate should fall to 5.2 percent by the end of the year, indicating that the economy is moving toward the Fed’s definition of full employment. In 2014, in seven of the first 11 months of the year, creation of high-wage jobs outpaced low-wage jobs. That trend should continue this year. With the unemployment rate falling, millions of people per month are now leaving their jobs for better opportunities. The labor market should therefore continue to tighten, attracting people who have been outside the labor force in the wake of the financial crisis. This should create the conditions for a rise in real wages to 2.5 to 3 percent this year.

Inflation

One major economic and policy narrative this year will be the coming sharp decline in the top-line consumer price index due to falling oil and gasoline prices. Concerns about deflation, which were evident in the recent decline in the Fed’s five-year forward breakeven inflation rate to 1.9 percent, should affect the timing and pace of Fed rate increases this year.

On a year-ago basis, the CPI is up 1.4 percent. Given the 40 percent drop in oil and gasoline prices over the past six months it would not be surprising to see either a flat or negative print on inflation by mid to late 2015. Once oil and gasoline prices stabilize, the CPI will move back toward the Fed’s long-term inflation target of 2 percent in late 2016 or early 2017. Although policy makers aren’t likely to confuse a one-time adjustment to the price level with a persistent decline in the total rate of inflation, falling inflation expectations will probably lead the Fed to adopt a gradual and orderly rate hike campaign.

Government and Trade

Outlays at the federal, state and local level related to higher tax revenues as a result of stronger economic growth should increase near a 1 percent rate, possibly even higher if federal defense spending grows. Meanwhile, the economic deceleration in Europe and China, along with competitiveness issues associated with a stronger U.S. dollar, should result in a net drag on U.S. economic growth of 0.5 percent this year.

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